Overview of Liquidity Management

In most businesses, cash flows in a triangular fashion from cash, to inventory, to receivables and back to cash. Since commercial banks are not permitted to pay interest on commercial checking accounts, there is lost earning capacity in dollars unnecessarily held in cash accounts. Many smaller business manage this problem by having interest bearing investment accounts into which they place the bulk of their excess cash and from which they, periodically, withdraw their working funds. There are several working formulas available to optimize these values, such as the Baumol model and the Miller Orr Model.

To control he amount of non earning cash, most companies require a cash budget which is designed to show, in advance, the excess cash likely to be generated and the shortfalls likely to be incurred. Such controls not only limit the amount of redundant cash but also control the bank line of credit costs likely to be charged when surprise cash demand occurs.

Since cash is primarily used for payroll and supply costs, the value of the inventory it produces in a manufacturing business represents and even more important potential management problem. Inventory held for sale is a non income producing asset and, unlike cash, it incurs additional overhead costs such as storage and handling and is , therefore, the most costly of all current assets to maintain. Strictly controlled manufacturing-to-demand and other 'Just in Time" techniques have substantially altered the traditional view of the amount of parts inventory necessary to meet customer requirements. The net result of improved inventory control practices, including the widespread use of computer programs, has been to make the traditional warehouse, and its attendant costs, virtually obsolete. An example of these inventory management practices can be found at the check out counter of the supermarket, where as each item is passed through the laser for pricing, its replacement is automatically ordered, thus eliminating the guess work and estimates that require huge costly oversupply.

The third element in the cash management triangle is credit. Almost all sales in manufacturing are on credit, where an order is received and the goods shipped on invoice to be paid in 30 to 60 days. Therefore, the amount of credit extended is a direct function of the sales activity of the business, and only infrequently is interest charged on these shipments. Failure to have a clear, competitive credit policy can create overdue accounts which may have substantial negative impact on cash flows.

The bottom line in liquidity management is that the dollars which are invested in this current asset triangle represent a permanent investment in assets which, while necessary to acquire business, do not themselves produce income for the business. On the other hand, since they have to be supported, they incur financial cost which has to be justified. Redundant cash, credit or inventory needs to be carefully managed if an otherwise successful business idea is going to bear fruit. Bank managers, who deal with this problem on a daily basis, will confirm that of all the pitfalls of running a successful smaller business, liquidity management is the one that requires the most attention.

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